ROI Guide: Internal Rate of Return

Definition: The internal rate of return (IRR) is the discount rate that results in a net present value of zero for a series of future cash flows.

What it means: It's a cutoff rate of return; avoid an investment or project if its IRR is less than your cost of capital or minimum desired rate of return.

Strengths: It provides a simple hurdle rate for investment decision-making. It's the method favored by many accountants and finance people, possibly the ones at your company.

Weaknesses: It's not as easy to understand as some measures and not as easy to compute (even Excel uses approximations). Computational anomalies can produce misleading results, particularly with regard to reinvestments.

IRR is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company's cost of capital.

IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV (and should be made) and above which an investment results in a negative NPV (and should be avoided). It's the break-even discount rate, the rate at which the value of cash outflows equals the value of cash inflows.

Consider the three scenarios shown here (see table), each involving an initial investment of $1 million. The investment returns $300,000 (undiscounted) per year in each of the five years after the initial investment, for a net return of $500,000.

A company evaluating this investment using cash flow discounted at 10% would compute an NPV of $137,000, a decent but not spectacular result. But if the company evaluates the same investment at 15%, the project has a present value of only $6,000, essentially just breaking even, and at 20% the project's present value is negative. The IRR is a fraction of a percentage point above 15%; at that discount percentage, the investment's NPV is zero.

IRR is often used as a hurdle rate, a sort of go/no-go investment threshold. Gaylord Entertainment Co. in Nashville, for example, has computed its weighted average cost of capital—a percentage that it won't disclose—and a "hurdle" percentage rate a few points higher. An investment's IRR must generally equal or exceed the hurdle rate to be approved by management, says CIO Kent Fourman.

"We calculate the IRR and then compare that to our hurdle rate," Fourman says. "And we compare that IRR against every other [project's] IRR, because you always have limited cash."

But the IRR cutoff isn't an absolute test, he says. For example, management's subjective assessment of risk may influence an investment decision, he says. "But if you can't show that IRR exceeds our hurdle rate, then you'll have to have a lot of the soft justifications to get it approved," Fourman says.

Not everyone is as enthusiastic about IRR. Like NPV, it doesn't measure the absolute size of the investment or its return. And because of the way the math works, the timing of periods of negative cash flow can affect the value of IRR without accurately reflecting the underlying performance of the investment.

IRR can also produce misleading results because, as classically defined, it assumes that the cash returned from an investment is reinvested at the same percentage rate, which may not be realistic. That error is magnified when comparing two investments of different durations. Some software, such as Microsoft Excel, will compute an optional "modified IRR" that allows the user to specify a different reinvestment rate.

IRR becomes increasingly misleading the more it diverges from the cost of capital, says Ian Campbell, chief research officer at Nucleus Research Inc. in Wellesley, Mass. "IRR is a terrible metric, and it should never be used," he asserts.

The key metric for IT projects, Campbell says, is payback period, because it favors short-term, and hence less risky, projects that IT should be doing.

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Internal Rate of Return: What It Looks Like

Discount rate: 10%

Discount rate: 15%

Discount rate: 20%

YearCash flowFactorAmountFactorAmountFactorAmount
0-$1 million1.000-$1 million1.000-$1 million1.000-$1 million
1+$300,0000.909$273,0000.870$261,0000.833$250,000
2+$300,0000.826$248,0000.756$227,0000.694$208,000
3+$300,0000.751$225,0000.658$197,0000.579$174,000
4+$300,0000.683$205,0000.572$172,0000.482$145,000
5+$300,0000.621$186,0000.497$149,0000.402$121,000
Total+$500,000

NPV = +$137,000

NPV = +$6,000

NPV = -$102,000

IRR = slightly more than 15%

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IRR is often used as a hurdle rate, a sort of go/no-go investment threshold.
In this example, there is an initial investment of $1 million, with a net (undiscounted) return of $500,000. The NPV of the $1 million outlay depends on the discount rate, or cost of capital, used to evaluate the investment. The NPV is zero at the IRR, here a fraction of a percentage point above 15%.

Special Report

Do the Math! An ROI Guide

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Copyright © 2003 IDG Communications, Inc.

  
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